Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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This candid and complete paper made by Josef Tošovský on the recent evolution of the Czech banking sector made me reconsider the general issue of restructuring the banking sector. In my comments, I will therefore share some thoughts both on the specific case of the Czech Republic and on the process of restructuring the Argentine financial system that occurred during the same period.

Some very important issues appear in Tošovský’s paper. Specifically, the paper rightly gives great importance to the need for banking sector liberalization, for privatizing public banks, and for opening the sector to foreign banks. These are fundamental themes, which should not be lost in the specifics of banking sector restructuring.

But, in addition, the paper presents important thoughts on the process of bank restructuring, including the need to take into consideration the legal infrastructure, the problems that rise from the shortage of human capital, and the problems of restructuring the financial system at the same time that the economy is undergoing general reform.

In the Czech case, the appearance of new private banks, facing a shortage of human capital, in an underdeveloped institutional framework posed additional challenges. Further, on top of the severe information problems related to the structural reform process, there was significant uncertainty at the individual firm level owing to the lack of credit histories, since most firms were newcomers. These features complicate even the most expert credit analysis.

The paper also emphasizes the need for an appropriate set of incentives for the private sector to recapitalize and restructure troubled banks, as part of a broader theme of minimizing the cost of restructuring.

Last, but definitely not least, Tošovský also effectively addresses the essential need to develop a well-designed prudential regulatory framework and a strong supervisory body to help in the transition and prevent future problems.

The Argentine Banking System in 1991

The Czech experience shares many similarities with the developments in the banking sector in Argentina, which occurred at the same time. In 1990, Argentina embarked on a program to end 50 years of economic policy based on government intervention, which had led to a highly regulated economy closed to foreign competition and which had resulted in the government’s direct involvement in the production of many goods and services, including banking services. High inflation, low productivity growth, and permanent external imbalances were the legacy of this economic policy.

As a result, Argentina, which had ranked tenth in the world in 1900 in per capita GDP, achieved the dubious honor of falling to forty-ninth in that ranking by 1989. This period ended with hyperinflation, a painful experience but one that gave the government the political support it needed to overhaul the economic system.

The new policy implemented in 1991 was based on ensuring price stability to investors, opening the economy to trade (both in the goods and capital accounts), reducing government intervention, and eliminating regulations. This program came to be known as the convertibility plan.

All economic sectors reacted favorably to the new policy environment and made the changes needed to increase productivity to compete internationally, an outcome that produced an annual rate of growth of 6 percent for the period 1991-96. The financial sector was no exception. This sector had developed the same shortcomings as the rest of the private economy.

First, the public banking sector was a significant force; in 1991, it included 6 national banks and 29 provincial banks, accounted for 46 percent of the nation’s deposits, and set the standard for efficiency, even for the 132 private sector banks. The structure of the financial system, with this very large number of banks, was therefore highly inefficient. The average cost of intermediation in 1991 was 10.1 percent of assets. One explanation for this inefficiency is the fact that—in the aggregate—the banks had very little business: the level of monetization of the Argentine economy plummeted from 45 percent of GDP in the 1940s to a mere 5 percent in 1989, basically owing to the high negative real interest rates that existed during most of the period. On the other hand, the public sector banks received permanent subsidies through the sharing of the inflationary tax, via rediscounts again, at negative rates.

The private sector banks were no less protected since their main competition was from the public banks. They also received frequent bailouts through devaluation and rapid changes in the rate of inflation—policies that reduced periodically the value of their liabilities—and also through some specific policies, such as special rediscounts from the central bank.

The incentives, even for the private banks, to conduct high-quality credit evaluations were weak. For many years, the real interest rate was negative, so that the credit officer had a very easy job: that of granting subsidies. Moreover, in the latter part of the 1980s, the external debt crisis led the national government to finance fiscal deficits in the banking system, and so the banks lent very little to the private sector of the economy. If this was not enough to produce a weak management structure, the high volatility of relative prices, owing to inflation and devaluation, did the rest, making it almost impossible to screen good from bad projects.

At this time, the work of Argentina’s Superintendency of Banks (the main supervisory body) was concentrated on controlling some important policy objectives, namely compliance with foreign exchange controls and lending to the government, through the reserve requirements. Little attention was placed on the proper supervision of prudential regulations.

The restructuring of the banking sector, which occurred during the period 1991-96, first aimed to change the regulatory and supervisory system and then to address the more specific issues of restructuring the public and private banks.

Regulatory and Supervisory System

Reform of the regulatory and supervisory system was of the utmost importance. Prudential regulations had to be put into effect, and a restructuring of the role of the superintendency was needed, to shift from supervising whether exchange rate controls and reserve requirements were met, to determining whether banks were meeting prudential regulations.

Emphasis was given to five regulations: (1) capital requirements, (2) credit quality, (3) liquidity requirements, (4) loans to associates, and (5) loan concentration. With respect to capital requirements, the recommendations of the 1988 Basle Accord were introduced in 1991, but with higher numbers. Instead of adopting the 8 percent risk-weighted capital-asset ratio, Argentina uses an 11.5 percent requirement, to take into consideration the higher need for capital in a banking system subject to restructuring and operating in an economy in the process of general reform. In addition, the capital requirements increase with the interest rate charged on each specific loan, to take into consideration the higher risk present in credits extended at very high interest rates.

However, it is not enough to have a good capital-to-asset ratio, since capital itself is the difference between credits outstanding and liabilities. It is also of the utmost importance to have a good measure of the quality of the loan portfolio. The regulation concerning provisioning was completely overhauled, moving to an analysis of cash flows for commercial credits (arbitrarily defined as those larger than $200,000) and leaving a quantitatively oriented method for analyzing the quality of consumer credit.

The liquidity policy was based on the reserve requirements imposed on banks, which, given the convertibility plan, implied that the banks held internationally liquid assets in proportion to their deposits. This policy, which was very useful in dealing with the 1995 liquidity crisis, had one problem. Since reserve requirements, being nonremunerated, were imposed on the more inelastic liabilities of the banks—namely, checking and saving accounts—the amount of systemic liquidity that a bank had depended on the proportion of liabilities held as sight deposits, a variable that proved to be inversely related to the run on the bank.

A general overhaul of the system was completed at the end of 1995, substituting reserve requirements for liquidity requirements. The banks now have to hold internationally liquid assets in their portfolios in common proportion to all of their liabilities, the proportion changing from zero percent to 17 percent according to the time remaining to maturity of the liability. Today, the level of liquidity requirements of the financial system is on the order of 17 percent of deposits and will rise to 20 percent by the beginning of 1997. This policy has been complemented by a strict surveillance of the liquidity gap, and by a $6.1 billion contingent line of credit that will provide liquidity against Argentine public bonds that banks already have in their portfolios and that amount to more than 10 percent of total deposits. So, if one takes systemic liquidity as a whole, the system will be operating at a level of liquidity of some 30 percent of deposits.

Another issue to which special attention has been given is associated or “connected” lending (to insiders or others associated with the bank). In Argentina—as in many other countries—bank failures have occurred largely because of poor lending practices or outright fraud. Even though it is very difficult to prevent fraud, the Argentine authorities have established severe limits to connected lending and also have monitored this regulation. Last, but not least, standard international limits for the concentration of the loan portfolio were adopted.

With these prudential regulations in place, the next step was to reorganize the Superintendency of Banks, so as to give this agency the precise powers necessary to be effective in controlling banks. The new charter for the central bank established, first, the independence of the central bank in matters related to monetary policy. Additionally, it created the Superintendency of Banks, which is within the central bank but retains a certain degree of autonomy to pursue its own objectives. There have also been changes in methods and in the qualifications of the personnel. In particular, the supervisory method adopted resembles that used in the United States, being based on “on-site inspection” leading to a CAMEL rating.

Restructuring the Public Banks

The solvency problems of public banks had, as their source, the incentives of the authorities in the past. These led to lending policies that were at best arbitrary and at worst driven by clear noneconomic motives. In addition, a lack of adjustment at the national and provincial levels contributed to the problem, as governments saw their banks as a financing tool. The inflationary tax was crucial to maintaining these inefficiencies.

The restructuring of a provincial bank is the decision of the provincial government, so that a set of incentives had to be put into place to protect the privatization process. The price stability that resulted from the convertibility plan eliminated the inflationary tax as a source of funding and so changed the political economy of the public banks. On the one hand, the banks could no longer be used as a financing tool by the government, and the inefficiencies of the banks caused losses that had to be covered. Provincial banks, which up to then were regarded by the provincial governments as a source of income, became a source of expenditure, and hence the incentives to dispose of them started to work actively.

With the incentives in place, what was required were the instruments to achieve their ends. The scheme developed consisted of removing some nonperforming credits from the balance sheet of the bank, leaving them in a residual bank, and replacing them on the asset side with support provided by a special fund: the Provincial Development Fiduciary Fund, which was created to aid in the recapitalization and privatization of provincial banks. Funds from the Inter-American Development Bank ($750 million) and the World Bank ($500 million) and a $1 billion contribution from the state yielded the resources.

The fund could directly lend to banks in the process of privatization or buy assets from them. More generally, it could also lend to the provincial governments, which were privatizing provincial enterprises.

In practice, when a bank was being privatized the provincial authorities created a business unit, to be sold, comprising selected assets and liabilities from the former provincial bank. The remaining assets, typically of dubious quality, were allocated to a residual bank through which the fund provided assistance to the province. The provincial government would then seek a third party to manage that residual portfolio, which could be the newly created bank or another party.

The loans are disbursed in two tranches. The first is one-third of the total amount and is paid when the provincial authorities agree to a privatization program (which includes assuming part of the bank’s liabilities and guaranteeing the loan with its resources). The second tranche, the remaining two-thirds, is paid when the privatization process is completed (including the creation of a residual bank). The amount now committed is $1,217 million, with 79.3 percent already disbursed ($965.4 million).

Specifically, the fund has lent to help in the restructuring and privatization of 16 provincial banks, of which 14 are already privatized and the rest are in the process of privatization. Seven provinces still maintain public banks. Table 1 includes some details regarding bank restructuring in Argentina in both the public and the private sector. The privatizations lie behind the significant reduction in the number of public banks.

Table 1.Bank Restructuring in Argentina
Total number of financial institutions214206158148
Public banks35342920
Private banks and financial institutions179172129128
Deposit concentration in the private sector
Number of small institutions with 20 percent of the deposits138129103100
Deposits held by 20 largest institutions (in percent)66657874

Restructuring of the Private Banks

The restructuring process of private banks stemmed from a much more general transformation process, involving the comprehensive structural reforms implemented since the convertibility plan in 1991 and which eventually implied that the banking sector had to adjust to the new environment: price stability, the disappearance of the government as the main borrower, the growth of the financial system, the strong investment boom that boosted private credit demand, and the adjustment to the upgrading of prudential regulations to international standards, among others.

The restructuring of troubled private banks was conducted using two main instruments, to which a third has recently been added. The first two were (1) the new powers granted to the Superintendency of Banks, which allowed it to order a bank to provision bad loans, so as to increase capital to meet capital deficiencies, and, if those efforts failed, to sell the shares or to close the bank; and (2) a bank Capitalization Fiduciary Fund, which was funded with government resources coming from a bond issue of $2 billion and a contribution from the World Bank of $500 million.

The fund can directly inject capital into the restructuring bank, buy and sell its shares, buy part of its assets, or simply lend to it. The central bank can request from the fund the arrangement and transfer of assets and liabilities of restructuring banks. In practice, the fund has used two instruments to help in the restructuring process of troubled banks: long-term bonds that can be guaranteed or subordinated. These operations have backed mergers, acquisitions, purchases of branches, and transfers of assets and liabilities of restructuring banks. The fund has lent to 17 banks, for a total amount of $654.2 million of which $350 million is subordinated debt. In total, there were some 37 institutions involved in mergers and acquisitions.

Table 1 above also details the number of private financial institutions in Argentina over the period of convertibility and illustrates how deposit concentration has increased. In 1991, there were no fewer than 179 banks and other financial institutions. This number stood at 128 at the end of 1996, reflecting the considerable amount of restructuring that has already occurred in this sector in Argentina. Note that 20 banks accounted for 66 percent of the deposits in the private banking system in Argentina, whereas this figure had risen to 74 percent in 1996 reflecting increased concentration of deposits in the larger banks. Perhaps more telling, however, is the change in concentration at the other end of the distribution. In 1991, 20 percent of the deposits were accounted for by 138 of the smallest banks. By 1996, however, only 100 of the smaller institutions accounted for 20 percent of the deposits. There has then been a marked change in concentration within the small banks over this period.

The third instrument introduced in 1995 was a limited deposit insurance scheme. It is fully funded by banks paying a premium into an independent institution and creates no obligation on the part of the central bank. The premium is proportional to the degree of risk attached to each bank.

Recently, the deposit insurance agency, Sedesa, has been granted powers to inject capital, to lend, or to grant a put option on certain assets of a restructuring bank, with the objective of minimizing costs. Its funds can be used only if the direct cost of an operation is lower than paying the deposit guarantee, if the license of the bank to operate is to be revoked.

Since the start of this new role, Sedesa has been involved in just one case: it granted a put option to a solvent bank that was acquiring a set of assets and liabilities of a troubled institution. The nominal value of the assets was $74 million. This put has a lower potential cost for Sedesa than paying the deposit guarantee if the license had been revoked. Furthermore, it provided the right incentives to the acquiring bank to value as accurately as possible the assets of the troubled bank.

It should be emphasized that a guiding principle of Argentine policies, each time that public funds have been directly or indirectly committed in the restructuring of a troubled bank, is to minimize potential losses. The procedure has been that any offer to acquire a bank requiring assistance from the Capitalization Fiduciary Fund or Sedesa has to be subject to a bidding process, in which both national and international banks are granted the chance to improve on the initial bids. In addition, careful evaluations are made of the acquiring bank’s soundness to ensure that the new shareholders would not use the assistance to embark on a business that could end badly. In this sense, there was a clear consciousness on the part of the authorities to heal the banking system rather than create potential future problems.

Similarities Between the Two Processes

There are striking similarities between the Czech and Argentine restructuring processes. Both were conducted in the middle of a larger restructuring process, which included convertibility, privatization, deregulation, and the opening of the economy and the banking sector to competition. The structural changes in the economy led to a rapid growth of the financial system. In Argentina, the financial system more than quadrupled in both countries in relative size in just four years, from 5 percent to 20 percent of GDP.

These changes implied a considerable degree of uncertainty with respect to the final set of relative prices, and it is inevitable that lending to the private sector in that environment would entail some mistakes. Those mistakes were even larger owing to the lack of good information and shortages of good credit officers; in the Czech case, the large privatization effort and the appearance of new firms were especially to blame, while in Argentina hyperinflation made past experience almost worthless.

The need to establish prudential regulations and to rebuild bank supervision is another similarity between the two countries. In the Czech Republic, a regulatory body for banking supervision was established in 1991; in Argentina, the Superintendency of Banks and the related prudential regulations were subject to a general overhaul at that time. The experience with the restructuring of the public banks was very similar, in the sense that the nonperforming loans had to be set aside and assumed by the central or provincial government, and the performing loans had to be transferred to a new bank to be privatized or to an existing private bank.

Restructuring: A Continuous Process

I agree with Tošovský that restructuring is not a once-and-for-all action, especially in this fast-changing world. In particular, financial sector restructuring is an ongoing process. Furthermore, it is not a process dictated or even driven by the authorities, but driven by the market and dependent on technological advances and changes in the demand for different and ever-more sophisticated financial services. Inevitably in such processes there are winners and losers.

What is needed, on the part of authorities, is to build institutions that can reduce banking problems and mitigate their cost when they occur. A set of good prudential regulations and a strong supervisory system are essential institutions to prevent problems, and a limited, privately funded, and risk-related system of deposit guarantees, together with some mechanism for providing capital to help in the process of restructuring, are institutions that may help to solve any problems that occur.

In sum, Argentina and the Czech Republic most differ in their respective starting points: their market environments, the depths of development of their private sector banking, the existence of know-how and human capital in their banking sectors, and the presence of well-designed regulatory frameworks and supervisory bodies to minimize moral hazard problems. In all of these areas, Argentina had an advantage. Nonetheless, there is a shared concern by both countries of the need to pursue all possible avenues to minimize the cost of bank restructuring to the government and depositors, and the need for careful monitoring to avoid potential fiscal costs in the future.

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